By Steve Lentz, Director of Research & Education, Series 3 OptionVue Research, Inc. Equity option sellers should consider futures options for one very big reason…more liberal margin requirements. This difference between the two worlds, equities and futures, is so dramatic that expected returns can vary more than two-fold on duplicate spreads in corresponding chains. For the option seller, this can mean big money. First, though, let’s take a look at the current situation regarding option implied volatilities as displayed in the Survey Report of the most liquid assets from OptionVue 5. As option sellers, whether in equities or futures, we need to make sure the market environment is right for these types of trades.
Currently, the financial indexes and interest rate markets have very expensive options, with implied volatility (IV) percentile rankings in the 90s. In fact, the volatility chart for the S&P 500 index reveals that IV is at a multi-year high! This means that short option positions can bring-in record levels of option premium. This applies to both the $SPX cash options and the SP 500 futures options.
Also, notice that of the top eleven most liquid option chains traded in the United States, seven of them are in the futures markets. As an option seller, this is very important. If you want out of a short option position, liquidity can be your best friend if the underlying asset is rapidly moving against you. But how can we best take advantage of these high liquidity and IV levels? High and declining implied volatility is best exploited using short option positions…short straddles, strangles, credit spreads, or ratio writes. All these strategies may be applied in either equity or futures markets, and all require the use of margin since premium is collected and not paid. Futures margin requirements, though, are more aggressive than in equities. This means that the risk to reward ratios are far better using futures options than equity options. Let’s take a look at an example. For the sake of argument, let’s assume that we believe the equity markets are near their bottom and will turn around and meander their way upward. Since options trade both as cash options on the S&P 500 index as well as futures options on the S&P 500 index future contracts, we can create and compare duplicate positions in each option matrix and Graphic Analysis. One short option strategy to consider is a “ratio write”, whereby we sell multiple numbers of out-of-the-money put options for every nearer-to-the-money put option that we purchase. This is done at a net credit, thus requiring the use of margin. Also, this strategy exploits the “volatility skew” seen for years in the S&P 500 out options.
In the S&P 500 Matrix, notice that this trade involves purchasing the Nov 770 put and selling three of the Nov 740 puts. The purchased 770 put has an IV level of 38.3% while the sold 740 puts have a higher IV level of 41.2%. This is called trading with the skew, and helps give us higher expected returns.
In the Graphic Analysis screen, notice that the net requirement to initiate this trade is $20,253 and the amount collected is $9,300. This represents a 46% yield. The expected return is $2,621. Now, if we did this same option spread in the $SPX cash options, the figures are far different. Please see the Graphic Analysis below for that trade.
Notice that the net requirement is much higher at $25,419 and that the amount collected is only $3,710. This shows how the more restrictive margin requirements can impact a trade’s results. This amount collected represents a yield of just 15%, barely a third of what you could get from the futures options trade. Also, the expected return is $1,228, not even half that of the futures options trade. For option sellers, these differences are substantial, and should be considered carefully in determining whether or not to switch to futures options. * Option strategies carry inherent risk of large potential losses. As such, these strategies may not be suited to every investor. |
